Introduction

In less than 10 years, cryptocurrencies have gone from digital curiosities to trillion-dollar technologies that could upend the global financial system. An increasing number of individuals are investing in Bitcoin and numerous other cryptocurrencies as investments, and utilizing them for purchasing software, virtual properties, and illicit substances.

To their fans, cryptocurrencies are a democratizing force, taking power away from central banks and Wall Street. To their critics, they empower criminal organizations, terrorist groups, and rogue states while exacerbating inequality, suffering from wild market volatility, and guzzling vast amounts of electricity. Regulations vary wildly around the world, with some governments embracing cryptocurrencies and others banning or limiting them. As of January 2024, 130 countries including the US are considering their own central bank digital currencies (CBDCs) to compete with the cryptocurrency boom.

What are cryptocurrencies?

So-called for their use of cryptography to mint virtual coins, cryptocurrencies are traded on decentralized computer networks between people with virtual wallets. These transactions are recorded publicly on distributed, tamper-proof ledgers called blockchains. This open-source framework means coins can’t be duplicated and no central authority (like a bank) is needed to verify transactions. Bitcoin, launched in 2009 by the pseudonymous software engineer Satoshi Nakamoto, is by far the most well-known and its market cap has hit over $1 trillion. Many others, including Ethereum the second most popular, have emerged in recent years.

Cryptocurrency users send funds to digital wallet addresses. These transactions are then recorded into a sequence of numbers called a “block” and verified across the network. Blockchains don’t record real names or physical addresses, only the transfers between digital wallets and so provide a degree of anonymity to users. Some cryptocurrencies, like Monero, claim to provide more privacy. But if the owner of a wallet is identified, their transactions can be traced.

Bitcoin “miners” earn coins by solving complex math problems to organize these blocks, thereby verifying transactions on the network; this is called “proof of work”. This method is utilized by numerous cryptocurrencies, while Ethereum and a few others employ a validation method known as “proof of stake.”. In Bitcoin’s case, a block is added to the chain every 10 minutes, and a new Bitcoin is awarded. (The reward decreases over time.) The total supply of Bitcoin is capped at 21 million coins but not all cryptocurrencies have this limit.

Note: This is a simplified explanation. There’s much more to the technology and mechanics of cryptocurrencies.

The price of Bitcoin and many other cryptocurrencies is determined by global supply and demand. But the price of some cryptocurrencies is fixed because they are backed by other assets and so are called “stablecoins”. These coins claim to be pegged to a traditional currency, like $1 per coin. But many of these were knocked off their peg during the recent volatility

Why are they so popular?

Once considered a niche interest of tech enthusiasts, cryptocurrencies—especially bitcoin—have gone mainstream and are now trillion-dollar valuations. In November 2021, the price of Bitcoin hit over $60,000 for the first time, though it has since dropped. As of mid-2023, 17% of US adults polled by the Pew Research Center had invested in, traded, or used cryptocurrency.

Different currencies have different draws, but the popularity of cryptocurrencies is largely due to their decentralized nature: they can be sent quickly and anonymously, even across borders, without a bank The transaction might be blocked or a fee could be charged. Dissidents in authoritarian countries have raised funds in Bitcoin to get around state controls, including to avoid US sanctions on Russia.

Some say digital assets are just investment tools. CFR states that individuals purchase cryptocurrencies due to a speculative belief that these tokens will increase in value in the future as a new future is being constructed on the blockchain. Senior Fellow Sebastian Mallaby. Some bitcoin enthusiasts see the cryptocurrency as a hedge against inflation because the supply is fixed, unlike fiat currencies which central banks can print more of. But after bitcoin tanked during the 2022 stock market volatility, many experts questioned that argument. The value of other cryptocurrencies is harder to explain, though many are tied to a larger project in the digital asset space. Some cryptocurrencies, like Dogecoin, were created as jokes but have value and have investors from high-profile individuals.

In countries with weak currencies, including several Latin American and African countries, bitcoin has become popular with populist leaders. In 2021, El Salvador made headlines by becoming the first country to make bitcoin legal tender (residents can pay taxes and settle debts with it), though only 15% of people had According to a survey conducted by Central American University, it was utilized for that intention in 2023.

The price of Bitcoin and other cryptocurrencies goes up and down wildly and some say that limits their use as a means of transaction. (Most buyers and sellers don’t want to accept payment in something whose value can change dramatically from day to day.) But some businesses accept bitcoin.

Experts say stablecoins could be more useful than other cryptocurrencies as a means of payment. The value of stablecoins is, as their name implies, relatively stable and they can be sent instantly without the transaction fees of credit cards or international remittance services like Western Union. Plus, because stablecoins can be used by anyone with a smartphone, they offer the opportunity to bring in millions of people who don’t have traditional bank accounts into the financial system. But they have come under increased scrutiny from regulators especially after several stablecoins fell below their $1 pegs during 2022’s market volatility.

What is “DeFi”?

Cryptocurrencies and blockchains have given birth to a new set of “decentralized finance” or DeFi companies and projects. Essentially the cryptocurrency version of Wall Street, DeFi aims to give people access to financial services—borrowing, lending and trading—without the need for traditional institutions like banks and brokerages that take big commissions and fees. Instead “smart contracts” execute transactions automatically when certain conditions are met.

DeFi apps mostly rely on the Ethereum blockchain. Blockchain’s ability to monitor transactions extends beyond cryptocurrency and has various applications such as in international trade. Experts believe that a new financial system can be established using blockchain-based tokens, which are considered superior to traditional centralized forms of currency.

What are the problems?

Trust is placed in the code, blockchain, and decentralized ledger, leading to a new approach to finance. However, cryptocurrencies have brought about a new set of challenges for governments, including dealing with criminal activities, environmental impact, and consumer protection concerns.

Criminal activity. 

Criminal activity has been on the rise, with cybercriminals executing ransomware attacks and demanding payments in cryptocurrency.

Additionally, virtual currency is increasingly being utilized by drug cartels and money launderers, and several darknet markets have been taken down by U.S. and European authorities. Despite enforcement efforts, a North Korean hacking group managed to steal over $1 billion in cryptocurrency in 2022. Terrorist groups and countries facing economic sanctions, such as Iran, North Korea, and Russia, are turning to cryptocurrency to evade sanctions, leveraging its decentralized nature to bypass traditional financial systems.

Environmental damage.

The energy-intensive process of Bitcoin mining has raised concerns about its environmental impact, as the network now consumes more electricity than many countries. To address this, proponents suggest using renewable energy sources, with El Salvador’s president pledging to utilize volcanic energy for bitcoin mining. Ethereum has also transitioned to a proof of stake model in response to environmental concerns.

Terrorism and sanctions evasion.

The rapid growth of cryptocurrencies and DeFi companies has resulted in billions of dollars being transacted in a largely unregulated space, leading to concerns about fraud, tax evasion, cybersecurity, and financial stability. If cryptocurrencies were to become the global payment system, it could limit the ability of central banks, particularly those in smaller countries, to control the money supply and set monetary policy.

Volatility and lack of regulation. 

In 2022, the value of several prominent cryptocurrencies decreased significantly due to high levels of volatility, leading to a number of crypto firms being unable to repay their lenders, resulting in bankruptcies and substantial losses for investors, including the collapse of FTX, the world’s third-largest cryptocurrency exchange at the time. These events prompted calls for a complete crypto ban, although traditional financial firms were relatively unaffected.

What are governments doing about this?

Many governments have taken a hands off approach to crypto but its rapid growth and evolution and the rise of DeFi has forced regulators to start making rules for the space. The regulations differ greatly across the globe, with certain authorities supporting cryptocurrency while others completely prohibit it. Regulators face the task of developing regulations that control conventional financial risks while still allowing for innovation.

In the US, policymakers have started to regulate some crypto and the DeFi space. In January 2024 the US Securities and Exchange Commission (SEC) approved the first set of exchange traded funds (ETF) that include bitcoin, allowing the cryptocurrency into the traditional securities market. But crypto doesn’t fit into the existing regulatory framework so lawmakers will have to figure it out. SEC Chairman Gary Gensler has called the crypto space a “Wild West” and compared it to the 1920s before the US had securities laws; he has urged Congress to give the SEC more oversight of bitcoin and other cryptos.

Both Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen have urged for more robust regulations of stablecoins. But regulators have been reluctant to give crypto investors the same protections as traditional finance such as deposit insurance. To limit illicit activities authorities have targeted the exchanges that allow users to convert crypto to US dollars and other national currencies. Under pressure from regulators major exchanges including Coinbase and Gemini follow “know your customer” and other anti–money laundering requirements.

Law enforcement and intelligence agencies are learning to leverage the traceability of most cryptos by using blockchains to analyze and track criminal activity. The FBI later managed to recover some of the ransom that was paid to the hackers of the Colonial Pipeline.

China which is home to most of the world’s bitcoin mining has gone hard on cryptocurrencies. In September 2021 Chinese authorities announced a blanket ban on all crypto transactions and mining and the price of some cryptocurrencies fell sharply immediately. According to the Atlantic Council at least 8 other countries (Algeria, Bangladesh, Bolivia, Morocco, Nepal, Pakistan, Saudi Arabia and Tunisia) have banned cryptocurrencies while dozens more have tried to restrict adoption of digital assets. But restrictions are hard to enforce and crypto exchanges have made tens of billions of dollars from countries with cryptocurrency bans. Meanwhile, most other governments have taken a relatively soft approach.

What is a central bank digital currency?

Many central banks, including the U.S. Federal Reserve, are contemplating the introduction of their own digital currency, known as a central bank digital currency (CBDC). Proponents argue that CBDCs offer the advantages of cryptocurrency without the associated risks. A large number of countries, which make up over 98% of the global economy, are currently investigating CBDCs, with 11 countries having already launched their own. Notably, 10 of these countries are in the Caribbean, with Nigeria being the 11th. In 2023, China began factoring its piloted CBDC into official currency circulation calculations, despite the digital yuan accounting for only 0.1% of central bank cash and reserves. In the U.S., there is a lack of consensus among Fed officials regarding the necessity of a digital dollar.

One proposed method for implementing CBDCs involves citizens having direct accounts with the central bank [PDF]. This approach would provide governments with new tools for managing the economy, such as the direct allocation of stimulus payments and other benefits. Additionally, the central bank’s endorsement would enhance the perceived safety of CBDCs as a digital asset. However, experts caution that this approach could lead to new challenges by consolidating a significant amount of power, data, and risk within a single institution, potentially compromising privacy and cybersecurity.

Some experts argue that the ability of CBDCs to bypass commercial banks as intermediaries poses a risk, as commercial banks play a crucial role in creating and allocating credit through making loans. If individuals were to bank directly with the Fed, this would require the central bank to either facilitate consumer borrowing, which it may not be equipped to do, or find new methods for injecting credit. For these reasons, some experts believe that private, regulated digital currencies are a preferable alternative to CBDCs.s.